Chapter 22 Learning Objectives Accounting Changes and Error

Chapter 22
Learning Objectives
Accounting Changes and Error Analysis
1.  Types of accounting changes
2.  Changes in accounting principles
3.  Retrospective accounting changes
4.  Impracticable changes
5.  Changes in estimates
6.  Changes in a reporting entity
7.  Correction of errors
8.  Economic motives for changing
9.  Analyze effect of errors
10. (Appendix) Change from or to equity method
Annual reports:
1
Accounting Changes and
Error Analysis
2
Accounting Changes and
Error Analysis
§  Estimates and uncertainty may require
adjustments when resolved
§  Most accounting principle changes
occurs because of new FASB rules
§  Most errors occur because of improper
revenue recognition (too early)
3
Learning Objective 1
4
Types of Accounting Changes
§  Types of accounting changes
1.  Change in accounting principle
2.  Changes in accounting estimate
3.  Change in reporting entity
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6
1
Change In
Accounting Principle
Change In
Accounting Estimate
§  Change from one generally accepted
accounting principle to another
§  Result of new information
§  Estimate of lives of depreciable assets
§  Estimate of warranty expense
§  Estimate of uncollectible sales on account
§  Change from LIFO to average cost
§  Companies rarely voluntarily change
§  New FASB pronouncement usually
requires adoption of new principle
§  Timeline to comply (five years)
7
Change In
Reporting Entity
8
Error Correction
§  Change from reporting as one type of
entity to another type of entity
§  Change from non-GAAP to GAAP
§  Misapplication of GAAP
§  Computational mistake
§  Purchase or sale of subsidiaries
Not principle change
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10
Changes in
Accounting Principle
Learning Objective 2
§  Changes in accounting principles
§  Change from one GAAP accounting
method to another GAAP method
§  Average cost to LIFO
§  Completed-contract to percentage-ofcompletion
Disclose nature of and reasons for change in principle
and explanation of why newly adopted accounting
principle is preferable
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12
2
Not Change in
Accounting Principle
Reporting Changes
§  Three approaches
§  Adoption of a new policy in recognition
of events that have occurred for first
time or that were previously immaterial
is not an accounting change
1.  Currently (one time entry on income stmt)
2.  Retrospectively
3.  Prospectively (today forward)
§  FASB requires retrospective approach
§  Users can better compare results from one
period to next
GAAP changed: In past changes reported currently
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Retrospective Accounting
Change Approach
Learning Objective 3
§  Retrospective accounting changes
§  Company reporting change
§  Recalculates financial statements from
each prior period as if new accounting
principle had always been used
§  Adjust book value of assets, liabilities
§  One-time adjustment to retained earnings
as of beginning of first year presented for
lifetime cumulative effect on net income
IFRS uses retrospective approach
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Accounting Change:
Example 1
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Accounting Change:
Example 1
§  In past used completed-contract method
for long-term construction contracts
§  In 2014 changed to percentage-ofcompletion method
§  New approach provides a more
appropriate measure of income earned
§  For tax purposes, completed-contract
method used in past and future
§  Tax rate, 40%
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18
3
Accounting Change:
Example 1
Description
Construction in Process
Deferred Tax Liability
Retained Earnings
Journal entry beginning of 2014, year of change
Disclosure Requirements
Debit
220,000
Credit
88,000
132,000
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§  Nature of change in accounting policy
§  Reason for change (why it is better)
§  Method of applying change
§  Description of prior period information
that has been retrospectively adjusted
§  Cumulative effect of change on retained
earnings or other components of equity
or net assets in balance sheet as of
beginning of earliest period presented
20
Disclosure Requirements
§  Effect of change on
§  Income from continuing operations
§  Net income
§  Net assets
§  Performance indicators (ratios)
§  Any financial statement line item of
particular interest to lenders, investors
§  Financial statement line items that do
not change need not be shown
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After Change
Before
Change
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4
Accounting Change:
Example 2
Accounting Change:
Example 2
§  Accounting change occurs in 2012
§  Changed from completed-contract to
percentage-of-completion method for
long-term construction contracts during
§  For tax purposes, company uses
completed-contract method
§  Record 2012 journal entries for change
in accounting principle
§  Calculate 2012 net income, ending R/E
§  Beginning R/E 2011, $100,000
§  Tax rate, 35%
§  Used completed-contract in past and future
§  Adjust all tax consequences through
Deferred Tax Liability account
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Accounting Change:
Example 2
Date
2011
2012
Percentageof-Completion
$
780,000
700,000
CompletedContract
$ 610,000
480,000
Difference
170,000
220,000
Description
Construction in Process
Deferred Tax Liability
Retained Earnings
Journal entry beginning of 2012, year of change
35%
Tax
Effect
59,500
77,000
$
Debit
170,000
Net of
Tax
110,500
143,000
Credit
59,500
110,500
Pre-tax income
Income tax (35%)
Net income
$
Beg. Retained earnings
Accounting change
Beg. R/Es restated
Net income
End. Retained earnings
$
$
$
$
2012
700,000
245,000
455,000
496,500
110,500
607,000
455,000
1,062,000
Restated
2011
780,000
273,000
$
507,000
$
$
100,000
$
100,000
$
100,000
507,000
607,000
$
100,000
396,500
496,500
$
Previous
2011
610,000
213,500
$
396,500
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Description
Construction in Process
Deferred Tax Liability
Retained Earnings
Journal entry beginning of 2012, year of change
Pre-tax income
Income tax (35%)
Net income
$
Beg. Retained earnings
Accounting change
Beg. R/Es restated
Net income
End. Retained earnings
$
$
$
$
2012
700,000
245,000
455,000
496,500
110,500
607,000
455,000
1,062,000
Debit
170,000
Credit
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Direct and Indirect Effects
59,500
110,500
§  Direct Effects
Restated
2011
$
780,000
273,000
$
507,000
Previous
2011
$
610,000
213,500
$
396,500
$
100,000
$
100,000
$
100,000
507,000
607,000
$
100,000
396,500
496,500
29
§  Retrospectively apply direct effects of a
change in accounting principle
§  Line items directly impacted by change
§  Indirect Effect
§  Changes to current or future cash flows of
that result from making a change in
accounting principle
§  Profit-sharing, bonuses based on N/I
§  Do not change prior period amounts
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5
31
32
Learning Objective 4
§  Impracticable changes
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Impracticability
34
Learning Objective 5
§  Do not apply retrospectively if (any one)
§  Changes in estimates
§  Cannot determine effects of retrospective
application
§  Retrospective application requires
assumptions about management’s intent in
a prior period
§  Retrospective application requires
significant estimates that company cannot
develop
§  Apply change prospectively
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36
6
Changes in
Accounting Estimate
Examples of Estimates
§  Uncollectible receivables
§  Inventory obsolescence
§  Useful lives and salvage values
§  Future warranty costs
§  Recoverable mineral reserves
§  Changes in estimates are normal
§  Always reported prospectively
§  No retrospective treatment
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Changes in
Accounting Estimate
38
Prospective Change
§  Account for changes in estimates in
§  No change in previously reported
results
§  Opening account balances not adjusted
and no attempt is made to compensate
for prior events
§  Change effects current period and
future periods only
§  Period of change if change affects that
period only
§  Period of change and future periods if
change affects both
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Changes in Estimate:
Example 1
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Changes in Estimate:
Example 1
Calculate NBV at date of change in estimate
§  Purchased equipment, $510,000
§  Estimated life, 10 years
§  Estimated salvage value, $10,000
§  Straight-line depreciation
§  Depreciation recorded for 7 years
§  In 2012 (year 8), revised estimates
Calculation of Annual Depreciation
Equipment cost
$ 510,000
Salvage value
$ 10,000
Total depreciation
$ 500,000
Useful life (original)
Annual depreciation
10 years
$ 50,000
Calculation of Net Book Value at end of Year 7
§  Revised estimated total life,15 years
§  Revised estimated salvage value, $5,000
Equipment cost
Accumulated depreciation ($50,000 × 7)
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Net book value
$ 510,000
350,000
$ 160,000
42
7
Changes in Estimate:
Example 1
Changes in Estimate:
Example 1
Calculate revised annual depreciation
Calculate revised annual depreciation
Calculation of Revised Annual Depreciation
Equipment cost
$ 510,000
Revised salvage value
$
Accumulated deprecation
$ 350,000
Remaining depreciation
$ 155,000
Remaining life (15 − 7 = 8)
Revised annual depreciation
Calculation of Revised Annual Depreciation
Revised annual depreciation
5,000
$ 19,375
Description
Debit Credit
Depreciation expense
19,375
Accumulated depreciation
19,375
AJE: Revised depreciation amount after change in estimated life, salvage
8 years
$ 19,375
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Changes in Estimate:
Example 2
Changes in Estimate:
Example 2
§  Original cost $400,000
§  Original life 30 years
§  Original salvage value, $100,000
§  Original cost $400,000
§  Original life 30 years
§  Original salvage value, $100,000
Depreciation per year
=
$400,000 − $100,000
30
= $10,000
Description
Depreciation Expense
Debit
10,000
Accumulated Depreciation
Changes in Estimate:
Example 2
§  Improve asset at cost of $500,000
§  Increase salvage value to $250,000
§  Increase total life to 45 years
Accumulated Depreciation
Debit
?,???
10,000
Changes in Estimate:
Example 2
§  After five years of service
Description
Depreciation Expense
Credit
Credit
Original
Revised
Cost
$400,000
$900,000
Salvage
$100,000
$250,000
Acc dep.
$0
$50,000
$300,000
$600,000
30
45
Remaining dep.
Life
?,???
Remaining life
Depreciation exp.
30
40
$10,000
$15,000
8
Changes in Estimate:
Example 2
Cost
New estimated life
45
− Life consumed
5
Remaining life
40
Remaining depreciation
Remaining life
§  Prospective change
900,000
− Salvage value
− Acc. dep.
Changes in Estimate
§  From today forward
250,000
§  Not retrospective
50,000
§  Prior years not adjusted
Remaining dep. 600,000
=
$600,000
40
§  Change begins in current period and
continues in future periods
§  Called a change in estimate
= $15,000
Disclosures
Disclosures
§  Disclosure of changes in accounting
estimate made as part of normal
operations (bad debt allowances or
inventory obsolescence)
§  Not required unless changes material
§  Change in estimate that affects several
periods (such as a change in service
lives of depreciable assets)
§  Disclose effect on income from continuing
operations and related per-share amounts
of current period
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Learning Objective 6
§  Identify changes in a reporting entity
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Change in Reporting Entity
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Change in Reporting Entity
§  Presenting consolidated statements in
place of individual companies
§  Purchase or sale of subsidiaries in
consolidated financial statements
§  Changing companies included in
combined financial statements
§  Changing cost, equity, or consolidation
method for subsidiaries, investments
§  Retrospective
§  Restating financial statements of all
prior periods presented
§  Show financial information for new
reporting entity for all periods
§  Describe nature of change, reason
57
Learning Objective 7
58
Types of Accounting Errors
§  Correction of errors
§  Mathematical mistakes
§  Change estimate not properly made
§  Change from non-GAAP accounting
method to GAAP method
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60
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Correction of Errors:
Example 1
Correction of Errors
§  All material errors must be corrected
§  Called prior period adjustments
§  Recorded in year error discovered
§  Reported in financial statements as
adjustment to beginning balance of
retained earnings
§  Comparative statements
§  2013: Error discovered from 2012
§  2012: Failed to record $20,000
depreciation expense on building
§  Building is only depreciable asset
§  Correctly included depreciation expense
in tax return and correctly reported its
income taxes payable
§  Prior statements restated to correct error
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§  Straight-line used for both book and tax
§  Tax rate, 40%
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Correction of Errors:
Example 1
Total debit to expense should have been $52,000; Actual $40,000
Description
Retained earnings
Debit
12,000
Credit
No book / tax difference
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Correction of Errors:
Example 1
Correcting journal entry
Debit
12,000
8,000
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Correction of Errors:
Example 1
Credit to Deferred tax liab should not have been made; Reverse
Description
Retained earnings
Deferred tax liability
Correcting journal entry
Credit
65
Entry to credit accumulated depreciation not made; Make it
Description
Retained earnings
Deferred tax liability
Accumulated depreciation
Correcting journal entry
Debit
12,000
8,000
Credit
20,000
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11
Correction of Errors:
Example 1
Correction of Errors:
Example 2
§  Beg R/E January 1, 2013, $350,000
§  Net income for 2013, $400,000
§  2012: Discover inventory error in 2011
§  2011: Error occurred
§  Ending inventory overstated, $62,500
§  COGS understated, $62,500
§  N/I before taxes overstated, $62,500
§  Tax rate, 20%
§  After tax overstatement of N/I, $50,000
§  $62,500 × (1 – 20%) = $50,000
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Correction of Errors:
Example 2
Woods, Inc.
Statement of Retained Earnings
For the Year Ended December 31, 2012
Balance, January 1, as previously reported
Prior period adjustment, net of tax
Balance, January 1, as restated
Net income
Dividends
Balance, December 31
$
$
1,050,000
(50,000)
1,000,000
360,000
(300,000)
1,060,000
$44,000 × 3/5 = $26,4000 (future depreciation expense)
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Learning Objective 8
§  Economic motives for changing
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Motivations for Change of
Accounting Method
74
Learning Objective 9
§  Political costs
§  Capital Structure
§  Bonus Payments
§  Smooth Earnings
§  Analyze effect of errors
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Error Analysis
Balance Sheet Errors
§  Errors are prior-period adjustments
§  Report in current year as adjustments to
beginning balance of Retained Earnings
§  Answer three questions
§  Balance sheet errors affect only
presentation of an asset, liability, or
stockholders’ equity account
§  Current year error: Reclassify item to its
proper position
§  Prior year error: Restate balance sheet
of prior year for comparative purposes
§  What type of error is involved?
§  What entries needed to correct for error?
§  After discovery of error, how are financial
statements to be restated?
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Income Statement Errors
Counterbalancing Errors
§  Improper classification of revenues or
expenses
§  Current year error: Reclassify item to its
proper position
§  Prior year error: Restate income
statement of prior year for comparative
purposes
§  Counterbalancing errors will be offset or
corrected over two periods
§  Restatement necessary even if a
correcting journal entry is not required
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Counterbalancing Errors
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Counterbalancing Errors
§  If company has closed books
§  If company has not closed books
§  If error already counterbalanced, no entry
§  If error is not counterbalanced, make entry
to adjust current balance of R/E
§  If error already counterbalanced, make
entry to correct error in current period and
to adjust beginning balance of R/E
§  If error not yet counterbalanced, make
entry to adjust beginning balance of R/E
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Error Analysis:
Example 1
Non-Counterbalancing Errors
§  Not offset in next accounting period
§  Companies must make correcting
entries, even if they have closed books
§  Selected accounts as of Dec 31, 2012
§  AJEs required at year-end
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Account
Supplies
Salaries payable
Interest receivable
Prepaid insurance
Unearned rent
Interest payable
Debit
$2,500
Credit
$1,500
5,100
90,000
0
15,000
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Account
Supplies
Debit
$2,500
Credit
Account
Salaries payable
Supplies on hand at year-end, $1,100
Description
Supplies expense
Supplies
AJE if books not closed
Debit
1,400
Description
Retained earnings
Supplies
AJE if books closed
Debit
1,400
Debit
Credit
$1,500
Accrued salaries at year-end, $4,400
Credit
1,400
Credit
1,400
Description
Salaries expense
Salaries payable
AJE if books not closed
Debit
2,900
Description
Retained earnings
Salaries payable
AJE if books closed
Debit
2,900
Credit
2,900
Credit
2,900
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Account
Interest receivable
Debit
5,100
Credit
Account
Prepaid insurance
Accrued interest at year-end, $4,350
Description
Interest revenue
Interest receivable
AJE if books not closed
Debit
750
Description
Retained earnings
Interest receivable
AJE if books closed
Debit
750
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Debit
90,000
Credit
Prepaid insurance at year-end, $65,000
Credit
750
Credit
750
Description
Insurance expense
Prepaid insurance
AJE if books not closed
Debit
25,000
Description
Retained earnings
Prepaid insurance
AJE if books closed
Debit
25,000
Credit
25,000
Credit
25,000
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Account
Unearned rent
Debit
Credit
0
Tenant paid $24,000 for two years rent on Jan
1, 2012; Entire amount credited to income
Description
Rental income
Unearned rent
AJE if books not closed
Debit
12,000
Description
Retained earnings
Unearned rent
AJE if books closed
Debit
12,000
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Depreciation for 2012 recorded as $5,000;
Should have been $50,000
Credit
12,000
Credit
12,000
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Description
Depreciation expense
Accumulated depreciation
AJE if books not closed
Debit
45,000
Description
Retained earnings
Accumulated depreciation
AJE if books closed
Debit
45,000
Credit
45,000
Credit
45,000
90
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